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Financial Management - Capital Budgeting – A Conceptual Framework

Meaning of Risk and Uncertainty - Risk Analysis In Capital Budgeting

   Posted On :  20.06.2018 12:10 am

Risk and uncertainty are quite inherent in capital budgeting decisions.

Meaning of Risk and Uncertainty
 
Risk and uncertainty are quite inherent in capital budgeting decisions. Future is uncertain and involves risk. Risk involves situations in which the probabilities of an event occurring are known and these probabilities are objectively determinable. Uncertainty is a subjective phenomenon. In such situation, no observation can be drawn from frequency distribution. The risk associated with a project may be defined as the variability that is likely to occur in the future returns from the project. A wide range of factors give rise to risk and uncertainty in capital investment, viz. competition, technological development, changes in consumer preferences, economic factors, both general and those peculiar to the investment, political factors etc. Inflation and deflation are bound to affect the investment decision in future period rendering the deeper of uncertainty more severe and enhancing the scope of risk. Technological developments are other factors that enhance the degree of risk and uncertainty by rendering the plants or equipments obsolete and the product out of date. It is worth noting that distinction between risk and uncertainty is of academic interest only. Practically no generally accepted methods could so far be evolved to deal with situation of uncertainty while there are innumerable techniques to deal with risk. In view of this, the terms risk and uncertainty are used exchangeable in the discussion of capital budgeting.

The capital budgeting decision is based upon the benefits derived from the project. These benefits are measured in terms of cash flows. These cash flows are estimates. The estimation of future returns is done on the basis of various assumptions. The actual return in terms of cash inflows depends on a variety of factors such as price, sales volume, effectiveness of the advertising campaign, competition, cost of raw materials, etc. The accuracy of the estimates of future returns and therefore the reliability of the investment decision would largely depend upon the precision with which these factors are forecast. In reality, the actual returns will vary from the estimate. This is referred to risk. The term ‘risk’ with reference to investment decisions may be defined as the variability in the actual returns emanating from a project in future over its working life in relation to the estimated return as forecast at the time of the initial capital budgeting decision.
 
According to Luce R.D and H. Raiffa in their book, ‘Games and Decision’ (1957), the decision situations with reference to risk analysis in capital budgeting decisions can be broken into three types.

1. Uncertainty

2. Risk  and

3. Certainty

The risk situation is one in which the probabilities of a particular event occurring are known. The difference between risk and uncertainty lies in the fact that the variability is less in risk than in the uncertainty.

In the words of Osteryang, J.S. ‘Capital budgeting’ risk refers to the set of unique outcomes for a given event which can be assigned probabilities while uncertainty refers to the outcomes of a given event which are too sure to be assigned probabilities. 
Tags : Financial Management - Capital Budgeting – A Conceptual Framework
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